Credit crisis- a managerial failure?

The sub-prime crisis in the US and its impact on financial markets are seen as a failure of regulation to keep pace with innovation. Securitisation is good but we need to ensure that the risks inherent in it are properly understood and priced. Rating agencies are seen as contributing to the failure.

This is now common wisdom but it's interesting to look at the issue in managerial terms. I wrote in my previous blog about how a clever manager can emulate Mao Zedong's methods to achieve rewards not commensurate with his success. In many ways, the financial sector provides fertile ground for such managers. That's because banks are hugely leveraged. This creates huge incentives for managers to take high risks- if they succeed, there are large bonuses; if they fail, the shareholders get wiped out. Managers may lose out on stock options not cashed in but, by the time failure reflects in financial results, they will have made their pile.

John Kay has an interesting point on this in an article in FT. Managers typically go unsung and, perhaps, unrewarded when they take premptive action to avoid disaster. It is those who take calculated risks and win who get all the laurels.

Al Dunlap of Scott Paper declared his admiration for Rambo: “Here’s a guy who has zero chance of success and always wins.” But Mr Dunlap’s company was acquired by Kimberly-Clark, whose chief executive for 20 years, Darwin Smith, avoided the storm by taking the company out of the competitive coated paper businesses and into high-value-added consumer products. Mr Dunlap was a celebrity but Mr Smith is little known.

We prefer to read about Lee Iacocca and Lou Gerstner, who held the helm in the storm, or Jack Welch, ho managed the ship through turbulence largely of his own creation.

How do we deal with this syndrome? We need to encourage risk-taking, of course. But incentives for top management must be more carefully designed, as I have argued earlier, to take care of possible losses down the road than they are today. Secondly, the degree of leverage in financial firms must come down- I think this will happen in banks with the implementation of Basel II. Thirdly, the media must celebrate the triumphs of the quiet leader as often as they do those of the flamboyant variety.